Stephane Michel, senior portfolio manager at the international business of Federated Hermes, answers SCI's questions on ESG in the CLO space

Q: How does Federated Hermes integrate ESG in its CLO business?
A: CLOs are still very much a universe where we are trying to build an analytical framework that is comparable to what our equity colleagues have been able to do for much longer, due to the provision of data that we haven’t got. That’s the challenge for ESG across the whole spectrum of structured credit.

As my colleague Andrew Lennox noted when he spoke to SCI last November, we arrived three or so years ago with a mandate to build out the firm’s structured credit business, but to do so within the DNA of Federated Hermes, meaning that we needed to integrate ESG. We started our credit approval process with a blank sheet of paper and said how can we best do this our way?

Because we’d seen quite a lot of chat from investors when discussing ESG and it sometimes comes across perhaps as a bolt-on when everything else is finished. But for us, it truly is integrated because every part of the credit analysis and the due diligence and the investment approval has all got the ESG aligned.

Q: What are the specific challenges of integrating ESG in the CLO market?
A: What we’d like to have is some form of output that in some way at some point can be consumed by our investors. If we get our way, in time hopefully the PE sponsors in the world of loans will feel comfortable with public disclosure of their ESG data in their deals.

At that point in time, CLO managers will be able to not only do their analysis, but also report ESG factors in their deals. Or, if they don’t, we’re at least able to see a trustee report and look at the collateral and have some way ourselves of guesstimating the ESG factors contained in those deals. That kind of democratisation of data is the end goal that we’d like to see the industry arrive at.

That’s one of the issues in syndicated leveraged loans in general: forget ESG; just financial information is not readily available for people who are not involved in that particular field. This is something that will hopefully continue to improve over time.

Data disclosure is an issue, but so is performance history. It’s still obviously early days. We have as a house in the past shown the benefits of ESG within credit specifically, but we’re not yet able to do that for structured credit because the history is not there in terms measuring performance.

There have been studies by the Bank of England in regards to mortgages, for example, so there’s a bit of data coming through. But I couldn’t tell you for sure that good ESG gives you better credit performance in structured credit – we don’t have that empirical evidence.

Q: Can you work with that lack of evidence in the short-term?
A: For us, to a certain extent, it doesn’t really matter. If we go one step beyond that and say ESG is credit neutral and has had no particular upside to credit performance, have I still achieved something better by engaging with those issuers and pushing for a better social agenda or environmental records or stronger governance in the structure or internally within the managers?

If the answer to that is yes, then even if my pool hasn’t performed better necessarily, I’ve still made a positive contribution by investing this way. So, we’re not going to wait for the empirical evidence to prove itself because we don’t need to.

Q: Is the ESG data situation improving?
A: If you look at what’s happening, we are seeing progress. We’ve got the ELFA templates and everyone is focused on moving things in the right direction. From what I gather, the PE sponsors too now have an investor base that’s very demanding on their ESG credentials, so I think they’re on board.

The risk with all these things is that it becomes a marketing sticker and by having that sticker, investors feel like they have ticked the boxes if they select that particular deal without knowing whether it is truly beneficial or not. In the CLO space, we’ve had quite a few ESG deals, but the range of ESG integration and genuine ESG analysis is quite broad. So for the time being, what you’ll find is most of the deals are exclusions-based, where you could argue that their exclusions aren’t much different to what they were prior to the introduction of ESG criteria.

Q: So, there is still some way to go?
A: Yes. For us as an investor in CLO liabilities, what we’d like to see is a deeper application of the ESG principles in the process from beginning to end, including reporting. I have no way of knowing whether these deals are ESG, other than knowing they have ticked the boxes by not buying the assets that are excluded.

I don’t really know how the manager used the deals from an ESG perspective and this is where we really have to face up to the challenge of lack of transparency and data. Everyone doing the work right now is having to use a more qualitative framework than quantitative, because the data is not yet there to crunch.

And ‘qualitative’ isn’t necessarily apples and apples from one party to the next. So, we apply our own qualitative and where possible quantitative framework in terms of how we review all our CLO managers and CLO deals. But if I take at face value what one of my CLO managers says is good ESG and I just accept the same from the next CLO manager, without being able to dig into the data underneath, I have no way of knowing whether I’m really signing up to apples and apples or apples and oranges.

We have to rely on a bit of an agency model in the sense that for the current generation of ESG, you’re passing on your burden to the manager. But, in a way, it’s like the life cycle of how credit ratings evolved: in the beginning, there were just a handful of rated companies, so people did their own work based on the information they could find.

Then as agencies became more prolific, everyone started relying on the ratings. But ratings are still only a way of benchmarking for good credit investors – they’ll do their own work as well.

Ultimately, as good investors, we really want to do the look-through ourselves, so we need to keep pushing for transparency.

Mark Pelham